Mortgages, Taxes and Unicorn Swaps

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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One of the most powerful trends in modern finance is toward abstraction and away from the annoying random facts of physical reality. You can't go a week without reading about how the blockchain will revolutionize private stock markets, or syndicated loan settlements, or tuna, replacing current laborious manual procedures with instant electronic synchronization. It's not just a blockchain thing; index funds allow you to own "the stock market" while abstracting away from the particulars of any individual company. Nor is it even really a modern thing. The whole point of finance is to do this sort of abstraction, to replace "I have a goat now" with "I have tokens that will allow me to buy a goat later."

And then there's the U.S. mortgage industry, which is still run on random scraps of paper, all of which have to be signed in pen and notarized and put in just the right physical folder. Some people want to change that -- say by using "secure webcams to link borrowers and notary publics," so at least they don't all need to be in the same room -- but it's not easy:

The National Association of Secretaries of State held a conference in July that featured panels about remote notarization, and many state notary administrators were in attendance. While some were receptive to the idea, others challenged speakers on everything from fraud to whether video recording of a notary signing could be hacked.

Some administrators, sitting around tables arranged in a horseshoe, debated with a Quicken Loans speaker about if notaries would know whether a webcam signer was being held at gunpoint.

Come on. One problem with mortgages is that banks did try to abstract away from all the dumb physical-signature stuff, by creating MERS, an electronic mortgage registry -- sort of like DTC for stocks -- that allowed them to transfer mortgage entitlements without all the traditional signing and notarizing. It is a ... mixed bag. One way that the banks abstracted away from the signatures was by "robo-signing" documents that they probably shouldn't have, by failing to respect the formalities in ways that may have harmed homeowners. The mortgage system is archaic, but nobody seems to quite trust banks to modernize it.

Death and taxes.

Here is a curious argument from N. Gregory Mankiw that the estate tax is bad "because it violates a principle that economists call horizontal equity. The basic idea is that similar people should face similar tax burdens." So if two couples -- the Frugals and the Profligates -- each start businesses, work hard, and earn the same amount of money, they should each pay the same amount of taxes, even if the Frugals save all their money and the Profligates spend theirs. They do. But Mankiw thinks they don't:

Under an income tax, the couples would pay the same, because they earned the same income. Under a consumption tax, Mr. and Mrs. Profligate would pay more because of their lavish living (though the Frugals’ descendants would also pay when they spend their inheritance). But under our current system, which combines an income tax and an estate tax, the Frugal family has the higher tax burden. To me, this does not seem right.

Ah, see, the problem here is thinking that the senior Frugals pay the estate tax. They don't. They are dead when the estate tax is assessed. The two great inevitabilities are death and taxes, but death is in an important sense logically prior. When you pay taxes, you still (usually) prefer not to be dead. Once you are dead, you have no preferences about taxes. We could fund the government with a lovely, efficient, non-distortionary system of taxing only the dead, except -- and this is another key point -- the dead don't have any money. The incidence of the estate tax can't be on dead people. Once the Frugals die, their heirs have the money, and the estate tax taxes them. If the Frugals' children make $30,000 a year as art gallery assistants and also inherit $20 million, and Mr. and Mrs. Justnotrich's children make $30,000 a year as Wal-Mart employees and inherit nothing, it seems odd to say that they should pay the same taxes as a matter of horizontal equity

Elsewhere in taxes, Dean Baker occasionally writes about fun ways to prevent corporate tax evasion; the basic idea is to tie corporate taxes to the stock market, so that economic benefits to shareholders automatically go to the government as well. His main proposal is to require companies "to turn over a proportion of their stock in the form of non-voting shares" to let the government participate in profits; he also mentions Bruce Bartlett's idea "that the government tax corporations at some percentage of their market capitalization on a randomly selected date in the prior calendar quarter." If you tax, say, Apple in a way that is inextricably bound up with its stock market performance, then Apple can't tell shareholders one thing (that it makes a lot of money) while telling governments another (that it doesn't have much taxable income).

These are neat ideas if you want to tie corporate taxation to economic income, and why wouldn't you? Except that no one seems to actually want that. We want companies to pay their fair share of economic income, but we also want to give them incentives to invest and disincentives to overpay executives and so forth. The point of a tax system is not just to take a cut of everyone's economic income; it's to encourage some behaviors (by taxing them less) and discourage others (by taxing them more). It seems unlikely that anyone thinks our current system of incentives is exactly optimal, but the urge to tinker is pretty overwhelming, and it seems unlikely that anyone would be satisfied just taking the same share of every company's economic profits.

Also, obviously, what do you do with multinational companies? Saying that Apple should pay X percent of its market cap in taxes doesn't solve Apple's Irish problem, which is essentially about where Apple should pay its taxes.

Elsewhere, a Donald Trump presidency will of course be great for tax shelters.

Hedge funds.

I sometimes giggle about the fact that Bridgewater Associates' culture of radical transparency does not extend to fund naming:

Bridgewater, founded in 1975, operates three main funds: its actively-managed Pure Alpha fund, the $62bn All Weather “risk parity” fund, and Optimal Portfolio, a fusion of the two which launched in February 2015.

The passively-managed All Weather fund has risen 13.5 per cent in value this year, while Optimal Portfolio has remained flat. But the $69bn Pure Alpha fund has fallen 9.4 per cent.

So the Optimal Portfolio is not ... you would not exactly call it optimal, would you? If you were being radically transparent? I hope that the Optimal Portfolio has been sent to a room to sit in front of a camera and reflect upon its shortcomings. (I will allow Pure Alpha because alpha can be negative, and All Weather because sometimes it rains.) Anyway though, despite a few hiccups, people are loving Bridgewater these days, and it "has attracted $22.5bn after taking the unexpected step of opening its active funds to new money for the first time in seven years."

“Every investor’s going to have up years and down years. What we look at is whether the investor is sticking with their strategy, whether their process continues to have integrity, whether their strategy seems to be appropriate,” said Bruce Zimmerman, chief investment officer at the University of Texas Investment Management Company.

There is a subtle question lurking here about what it is that Bridgewater does, and why. Every asset manager is to some extent in the business of trying to gather more investments (or at least keep the ones it has), and to some extent in the business of trying to make the investments it has go up. Bridgewater's process of radical transparency and extreme mindfulness might be a good way to find the investments that will go up. But it also seems like an excellent way to market to investors who will accept some down years, but who really want to make sure they're getting integrity of process. There's a lot of process, anyway.

Elsewhere in the hedge fund industry, assets are pretty much going the other way: Perry Capital, Paulson and Och-Ziff are all shedding investors. Elsewhere in asset management generally, factors are co-moving, low-volatility funds are volatile, and John Bogle doesn't think that index funds are worse than Marxism.


I've written before about the two kinds of whistle-blowers. There are the lovable rogues who are happy to commit fraud, and to report it to the authorities, and to get paid for reporting it. And then there are the too-pure-for-this-world types who are horrified by any whiff of scandal, and rush to report it to the authorities, and then are scandalized when the authorities aren't as horrified as they are. At the extreme, the purest whistle-blower will turn down his own whistle-blower bounty because he finds it scandalous too. This Monsanto guy isn't going quite that far, but he wants you to know that he's still mad:

“The company got fined and some money changed hands, but that’s not the answer,” the whistle-blower said in a telephone interview. “Management not being held accountable, that still bothers me. I went into this to get that fixed, and that didn’t get fixed.”

He got paid $22 million for blowing the whistle on Monsanto, but it was never about the money. It was about ... not seeing the world the way everyone else at Monsanto did:

“Nobody else feels what you feel internally, so you have a hard time understanding why people don’t see it as you do,” he said. “That’s the only way you can go through this: It’s got to be something from deep within that drives you.”

And you can't cure that with money. Whistle-blower bounties are only really good for motivating the lovable-rogue whistle-blowers. The too-pure whistle-blowers will always end up dissatisfied; that's how they became whistle-blowers in the first place. It seems a waste to give them the money anyway.

Fancy options.

This is not especially timely -- I'm 120 years late to it, actually -- but here's a paper from last month about an 1896 manual for London options traders that is too delightful not to mention here. The gist of it is that 19th-century options traders understood put-call parity and used pricing methods that pretty closely approximate the modern Black-Scholes results, at least for relatively easy options. Also they called the slightly harder ones "fancy options." And they had the basics of static delta hedging down:

Τraders in the late 19th century assumed that the sensitivity of the ATMF option prices with respect to the underlying was 0.5 and therefore considered ATMF straddles as “delta neutral” assets whose value depended only on the future fluctuation of the underlying. Huang and Taleb (2011) refer to Nelson (1904) who says that “Sellers of options in London as a result of long experience, if they sell a Call, straightway buy half the stock against which the Call is sold; or if a Put is sold, they sell half the stock immediately, finding that in the long run this method usually works out a profit.”

Meanwhile in 2016: "Vol is low, not cheap."

People are worried about unicorns.

Yesterday I found myself involved in a fun Twitter conversation about unicorn failure swaps. From time to time, people start asking (in the words of Vanity Fair's Maya Kosoff): "Why is there no way to bet against private tech companies?" 

Now, there are a couple of answers to this question. One is that, for most people, there is no easy way to bet on private tech companies; the fact that they're private means that for the most part only employees and venture capital firms get to invest in them. (I mean, you can buy some Fidelity funds for the Uber exposure, but not all that much.) So the market failure, for you and me, is on both sides. Another is that there are some indirect ways to bet against unicorns, for instance by shorting public companies that invest in or provide services to a lot of unicorns. Erin Griffith wrote about some of them at Fortune last month, which prompted me to point out another, even more straightforward method to profit from a startup bubble that you think is overvalued, which is to just start your own dumb startup to try to sell at the peak. 

But there is an even simpler answer, which is: You can bet on whatever you like. Just find a friend who loves Uber and bet him $100 that Uber will fail, or whatever. You'll have to work out the parameters and odds of the bet, and good lord is this not legal advice. (Gambling is ... frowned upon in some quarters.) But all the tools are there, except perhaps your friend.

Traditionally, if you don't have a friend willing to bet with you on random stuff, you can find a bank who will, for a fee, serve as that friend. (This is called a "swap.") A bank could write you a unicorn failure swap on Uber, where you pay the bank if Uber's valuation goes up (in an initial public offering or sale or whatever) and the bank pays you if it goes down. (The unicorn failure swap, or UFS, is a financial instrument that I just invented and really ought to copyright. Also you probably need to be an accredited investor to do a UFS with a bank.) But banks do not typically take the risk in trades like that; instead, they mostly intermediate them, giving you the short side of the UFS and finding someone else to take the long side. And who would take the long side of that trade -- basically making a zero-sum bet that Uber or whatever will go up -- when they could just invest in Uber instead?

I guess one answer is "people who can't actually invest in Uber," though it's hard to imagine there are too many of those. For other startups, maybe there are some. You could even imagine starting a Synthetic Unicorn Fund that invests in the long side of a lot of UFSes, giving it exposure to big tech unicorns without actually buying any shares. Register it with the Securities and Exchange Commission -- it is not obviously worse than other exchange-traded products that invest in illiquid derivatives with their sponsoring banks -- and you could even sell it to retail investors as a way to get access to hot tech startups before they go public. Then line up accredited-investor unicorn skeptics to take the other side of the Synthetic Unicorn Fund's swaps. Actually you might as well go all the way and register a Synthetic Unicorn Anti-Fund to take the short side too.

It could probably more or less be done. (Not legal advice. Also, if you do it, I would like a cut, particularly if you use my terminology.) There is precedent, though it is unfortunate precedent: The Sand Hill Exchange, co-founded by my Bloomberg View colleague Elaine Ou, offered synthetic contracts on pre-IPO startups, though it did not quite comply with SEC rules and was quickly shut down. My favorite oddity about the Sand Hill Exchange is that, even though it did offer the opportunity to bet against private startups -- and even though that opportunity seems to be both hard to find and in demand -- most people didn't take it. Most of the bets were long bets. That was in 2015, though; perhaps people are more worried about unicorns now.

Elsewhere: Jessica Alba's Honest Co. may be for sale. And: "How Pittsburgh Became Uber’s Testing Ground" for driverless cars.

People are worried about bond market liquidity.

In the Treasury market, worries about bond market liquidity tend to be of the "no one goes there anymore, it's too crowded" variety. So for instance here's a story about how it's no longer cool for banks to be primary dealers in the Treasury market, with Credit Agricole deciding not to pursue primary dealership. "There may be cause for concern if major global banks such as Credit Agricole are losing interest in underwriting U.S. debt." Except that the reason banks don't want to be primary dealers is that there's so much competition to buy that debt:

Dealers have bought about 32 percent of auctions this year, on pace for a record low, according to data compiled by Bloomberg. While that’s partly a result of the rise in direct bidding, dealers have also been left with less to purchase because of the insatiable demand for Treasuries from investors fleeing about $9 trillion of negative-yielding sovereign debt in places like Japan and Europe.

Elsewhere, remember last week, when the market was so good that junk-rated European companies could upsize payment-in-kind bond deals? Yeah that went poorly.

Things happen.

Global Selloff Threatens to Spiral as Central Banks Angst Builds. Banks can't find enough office space to relocate out of London into Europe. Woes at Italy’s Biggest Bank Reverberate in Europe. After 11 Years, Case of A.I.G.’s Ex-Chief Is Going to Trial. Setback for Investors in Fannie, Freddie. Potash Corp. and Agrium to Merge, Creating Fertilizer Giant. Linde, Praxair Said to End Talks on Concern Over Munich’s Role. HarbourVest Partners Offers to Buy SVG Capital for $1.35 Billion. The Last Word on Fed Policy Goes to Brainard. Commerzbank Plans to Dismantle Its Investment Bank, FAZ Reports. The ‘Last Bull’ in China’s Blue-Chip Market. Alexandra Scaggs on the Fed and collateral intermediation. Robin Wigglesworth on human extinctionProprietary trading: evidence from the crisis. Are Order Anticipation Strategies Harmful? America’s Biggest 401(k) Adviser Has a Plan to Manage All of Your Money. Financial Times masters in management rankings. EU to Get Tough on Chat Apps. "Peak oil" is not trendingGary Sernovitz on New York restaurant economics. FBI Says Problem Worker Set His Boss on Fire. Martin Shkreli taunts Clinton outside apartment after 9/11 ceremony. Hanjin’s Stranded Ships Contain One Absurdist Filmmaker.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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Matt Levine at

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